Inflation - is the threat really over?

CIO view

Those trying to see the outlook for the world economy through changes in capital markets’ prices had another disorienting week. Stock and credit markets continued their impressive start to the year. The message, in the face of economic and corporate earnings data that seemed unsupportive, was that inflation would soon be vanquished – normal business, and friendlier central banks, will shortly resume…

Of course, prices of stocks, bonds, and much of the rest tend to be forward-looking. Investors are not just trying to think about what is going on today, they are trying to anticipate what is in the path months and even years ahead. Economic, corporate, and other data are scoured for clues. Every utterance from the world’s central bankers is minutely dissected, as are the implied messages in their regularly updated forecasts. Somewhat confusingly, for all concerned, central bankers try to use this attention to guide investor behaviour, which investors obviously know and handicap accordingly.

So, we come to this week, a week where the Federal Reserve, European Central Bank, and Bank of England all raised interest rates again. All suggested more were ahead and all noted that inflation was still a clear and present danger. However, after the central bank shock and awe of last year, the much-prophesied peak in inflation and therefore interest rates has acquired mythical status amongst investors – with each false dawn, and accompanying plunge in stock and bond markets, the real peak – whenever that might finally arrive – gained in perceived importance.

There are two questions to ask. First, is this really the peak this time – is inflation really on the way back down to central bank targets? Second, is that really the only game in town for investors, or are there other factors that should dominate?

With regards to the first, we would certainly share some of the optimism evident amongst investors this week. All around the world, we are seeing signs of an ebbing tide in inflation. For several reasons, energy prices have retreated helpfully and our collective inflation expectations with them.[1] Wage pressures seem to be moderating in the US, even if the data are not quite speaking with one voice (Figure 1). Nonetheless, measured inflation remains uncomfortably high in much of the developed world and if the last year taught us anything, it is that betting the house on inflation forecasts is unwise – it is still such a poorly understood phenomenon.

On the second question, that of whether the peak in central bank policy and an ebbing tide in inflation is all you should care about – the answer is no. The dramatic surge in interest rates, still in motion albeit at less breath-taking pace, will come with an economic price. Just because we can’t yet see that price in much of the economic data, that doesn’t mean the bill won’t come due at some point. The leading indicators made for grim reading this week (Figure 2). Investors just seemed too jazzed by a fractionally more permissive tone from the central bankers to mind too much. We remain a little more circumspect in our tactical portfolio. There has been some good news on the economy of late and a peak in inflation really would be very good news for all. However, we are still only guessing at the impact a 500-basis point rise in 2-year US real interest rates will ultimately have on the global economy. We have learned over time not to ignore the ISM surveys nonetheless.

While all this central bank drama has been playing out in the foreground, we have had another slug of major companies telling us of their view of the world and the markets that concern them. There has been the usual mix of mostly carefully managed surprises. However, there are some warning signs to be seen here too. Revenues look mostly ok so far, but we are starting to see earnings expectations move to reflect a less sunny range of near-term scenarios (Figure 3). A peak in interest rates might be helpful for propping up valuations – a lower bar for future expected cash flows to hop over – however, those expected cash flows may still be too high if the leading indicators are right.

Finally, the UK. Again, the media is full of odes to broken Britain, spurred by a particularly gloomy take on the UK’s outlook from the IMF, as well as some predictable noise around the 3-year anniversary of Brexit. We’ve written before of the savage joy this country seems to take in rolling around in our (perceived) inevitable decline – it is a national pastime, alongside harmless prattle about the weather and not saying what we mean. The Bank of England joined the throng this week with a set of forecasts that pleased bond investors, but few others – a long, albeit relatively shallow, recession would seem to be ahead, one that we may have already begun. Those forecasts seem to have helped persuade investors that this interest rate rising cycle is coming to an imminent end. Soon the central bank will be desperately cutting interest rates, hence the plunge in gilt yields this week.

Perhaps. We have pointed out before that the UK economy has more than its fair share of challenges, in a world that is still full of them. We would still point out that there is much the UK can do to help itself and that forecasts, whether IMF, central bank or elsewhere, should not be leaned on too hard. There is much that can still go right (and wrong). That of course matters to us who live here and depend on the UK’s outlook for our livelihoods. However, the beauty of a globally diversified, multi-asset class fund or portfolio is that the UK economy doesn’t really matter. You are getting the world’s endlessly resourceful population working on behalf of your savings day and night. You just have to stick with it, even if there is still much to navigate in the months and quarters ahead. In that diversified investment exposure, you are helping to provide both the answers to the world’s many problems and hopefully, over time, giving your savings a chance to handily beat inflation over time.

[1] https://www.imf.org/en/Blogs/Articles/2023/02/02/looser-financial-conditions-pose-conundrum-for-central-banks?

Find out about our '?Ready-made investments' via our Smart Investor platform. A selection of five Barclays funds that each aims to increase the value of your investments over time, using a broad mix of asset classes from across the globe.

Or

Learn about?Barclays Wealth Management, the affluent and high net worth service provider for Barclays UK.

*This article is for information purposes only. It is not intended as a product offer or investment advice